In 1928, the Fed (US Central Bank) hiked rates thrice in an attempt to quell the prospects of a developing speculative bubble by encouraging investors to shore up the stability of the US economy by banking their assets.
In retrospect, most economists, especially monetarists, point an accusing finger at the Fed for the role they played before and during the Great Depression. The US, in a post-WWI environment, was an economic powerhouse to be reckoned with, due to the profitable war it just fought in Europe and the temporary new state of order arising from WWI. The US agricultural industry was booming on account of the drastic fall in supply in Europe and the high prevailing prices in commodity markets; durable goods consumption was also in good shape. Both were propelled by a credit boom involving US banks – growth in the years leading to the Great Depression was mostly funded by the availability of cheap credit, which in hindsight was badly allocated, resulting in a general over-exposure to bad credit. The recovery in agricultural production in Europe led to a severe glut of commodities which resulted in a sharp correction in agricultural prices throughout the 1920s and even protectionist measures by commodity producing countries could not dampen the downward trend.
Money supply in the US
This coincided in 1928 with the US central bank authorities hiking interest rates to 5% in a bid to quell the speculative bubble. Faced with a rising financing costs, many of the agricultural producers were now contemplating bankruptcy given their highly leveraged business model. This fed through banks’ balance sheets and resulted in numerous bank runs as savers worried about the safety of their monetary assets. Money supply in the US contracted severely, down nearly 30% from their pre-crisis levels and this amplified the credit squeeze and contaminated the whole economy, most notably the durable goods industry. The USD was by then under severe pressure and late in 1929, the Fed again hiked rates by 100bps to 6% in a last ditch attempt to anchor the currency. This would prove fatal…
Fast forward 85 years and many of the features of the Great Depression of 1929 are apparent in the world economy today. The Fed embarked on a massive money printing bonanza in the midst of the Financial Meltdown and inflated their money supply in a bid to inject much-needed liquidity in financial markets’ bloodstream. This move in unchartered territory lasted nearly 5 years and basically resulted in an excess of cheap credit in international money markets. This turned out to be the foundation of the recovery as those cheap funds were channelled mostly in emerging and commodity-based economies as investors piled in on the ‘quest for yield’ trades. Commodities’ prices went through the roof and emerging markets (EM) turned out to be the ‘growth’ element in the world economy formula. While post wartime geo-political dynamics drove the credit boom, quantitative easing by the US is behind the current cheap worldwide credit boom.
With the US now on an unquestionable stronger sustainable footing that at any time during the past few years, the Fed are considering closing the monetary taps and reduce the money supply in the system. These are daunting times for the world. We have already witnessed a sharp pullback in EM currencies versus the USD and the price of commodities have corrected as well. The timing of this proposed reversal of expansionary monetary policy by the Fed could well prove mistimed. Had Emerging Markets been at the expansionary point of their business cycle, the odds that they could stomach the flight of some capital flows from their economy would have been quite high but in the current circumstances, where China is trying to rebalance its economy and is suffering from a prolonged slowdown in its growth rate, the proposed Fed withdrawal of stimulus could prove ominous for the economy. In response to the depreciating storm facing their local currencies, Emerging countries including Brazil, India, Turkey, South Africa and Indonesia have hiked rates in a bid to bolster their respective plunging currencies. They are likely to be followed by others in EM space. Is that wise? Or is this going to prove fatal?
Long term implications
Hiking rates in an environment where the economy is facing numerous headwinds sounds counterproductive. While Central Bankers might be focusing on the stability of the local currency in the short term and aiming to prevent capital outflows by keeping the interest rate differential intact or even increasing it versus the developed world, they should also consider the long term implications of their acts. One cannot deny that Emerging Market currencies were one of the main beneficiaries of the Quantitative Easing programme of the US and that as such those currencies were bound to be inflated the day the Fed decided to start reversing their policy. Many EM states currently face the ‘double deficit’ syndrome of budget deficit and trade deficit in a chronic manner. While the former is often due to political decisions, the latter is usually a function of the prevailing exchange rate. A depreciating currency is often synonymous to imported inflation but it has more to it. Freely floating exchange rates act as an automatic stabilizer in open economies such that the depreciating currency would have boosted exports and reduced imports; thus improving the trade balance over the medium term. Central bankers need to be able to make the distinction between capital flows – some of them are short-term capital flows (hot money flows) in search of the highest return while a majority of it are long-term flows which are here to stay as long as the economic outlook looks attractive.
Higher interest rates will necessarily lead to higher financing costs for local companies which would be already facing difficult times due to the exodus of some capital from foreigners. All in all, rising interest rates in this environment looks suicidal and monetary authorities will have to backpedal at some point in the future. The longer they take to reverse their policy decisions, the more likely we are to have an EM crisis of such proportions that it could rival the recent Financial Crisis or, in the worst case scenario, pull the worldwide economy in recession. What goes up must come down and that is a universal law which humans can only delay…